The federal New Markets Tax Credit Program is a prime example of public-private partnerships successfully funding projects and businesses. Federal new markets tax credits (NMTCs) were created in 2000 to stimulate private investments in low-income communities and make otherwise difficult-to-develop projects feasible and viable. NMTCs have served as a source of funding for numerous types of real estate projects across the country, including schools, performance arts centers, theaters, health clinics, community and social services centers, hotels, office buildings, shopping centers, for-sale affordable housing and other nonresidential or mixed-use projects.
An investor may qualify for NMTCs by investing (directly or indirectly) cash equity in a qualified community development entity (CDE), which is typically a limited liability company that has received an NMTC allocation from the Community Development Financial Institutions Fund (CDFI Fund) of the U.S. Department of the Treasury. NMTC allocations of $29.5 billion have been made to CDEs since the inception of the New Markets Tax Credit Program, and $3.5 billion of additional NMTC allocations are expected in 2011 or early 2012.
Serving Low-Income Communities
A CDE must (i) have a primary objective of providing capital for or otherwise serving low-income communities or low-income persons, (ii) remain accountable to residents of low-income communities through their representation on the CDE’s governing or advisory board, if any, and (iii) obtain certification by the CDFI Fund. A low-income community generally is a census tract with a poverty rate of at least 20% or a census tract in an area where the median income is not more than 80% of the statewide median family income. A low-income person generally is an individual whose family income is 80% or less of the area median family income.
Subject to certain requirements described below, the NMTC is equal to 39% of the equity invested in a CDE and is claimed over a seven-year period (5% in each of the first three years and 6% in each of the remaining years). All of the previously claimed NMTCs will be recaptured with interest if, during the seven-year NMTC period, the CDE ceases to qualify as a CDE, fails to invest substantially all of the equity it receives for qualified investments, or redeems such equity.
Types of Businesses a CDE Can Invest In
To qualify for the NMTC, a CDE generally must invest (either as a loan or as equity) at least 85% of the equity it receives in one or more qualified active low-income community businesses (Business Owner), commonly known as a QALICB. A Business Owner is a corporation, a partnership or proprietorship that generally conducts a “qualified business” in a low-income community and satisfies certain income, services, property and other criteria. Because of the tax benefits, an NMTC investor typically allows a CDE to use the equity to provide a Business Owner with one or more loans that contain unconventional features, such as a below-market interest rate, lower origination fees, a longer period of interest-only payments, a higher loan-to-value ratio, a lower debt-service-coverage ratio and more flexible underwriting standards.
A “qualified business” is any trade or business other than: (i) leasing of unimproved real property or residential rental property; (ii) development or holding of intangibles for sale or lease; (iii) operation of a golf course, country club, massage parlor, hot tub or suntan facility, gambling facility or liquor store; and (iv) certain farming activity. A building is considered a “residential rental property” if 80% or more of its income is derived from the dwelling units; note that several strategies may be utilized to qualify mixed-use buildings as nonresidential rental property.
Debt Financing and Leverage Loans
Debt financing may be included as part of the equity investment for calculating the NMTC only if the borrower is the entity making the equity investment in the CDE and the financing is not secured by a mortgage or other assets of the Business Owner. Accordingly, debt financing intended to increase the NMTC ordinarily is made to an upper-tier investment fund (this type of financing is commonly called the Leverage Loan). The upper-tier fund combines the proceeds of the Leverage Loan and the capital contribution from the investor to make the equity investment in a middle-tier CDE.
Because of the tax benefits, an NMTC investor typically allows a CDE to use the equity to provide a Business Owner with one or more loans that contain unconventional features.
A governmental entity may participate in an NMTC structure in multiple roles: as an upper-tier lender of the Leverage Loan to an investment fund; as an affiliate of a middle-tier CDE formed to develop such entity’s own NMTC projects; as an insurer of a CDE loan to a Business Owner; or as a lower-tier lender to a Business Owner to supplement the CDE financing. The types of funding provided by a governmental entity in an NMTC structure may include: HUD Section 108, 220, or 221(d)(4) loans; HUD CDBG or HOPE VI loans; tax-exempt bonds; brownfields funds; and city tax incremental financing.
Adjusting to NMTC Arrangements
A governmental entity making a Leverage Loan to an upper-tier investment fund will need to get comfortable with issues such as the absence of a mortgage, required entrance into an intercreditor agreement with other Leverage Loan providers, forbearance for the seven-year NMTC period, the CDE’s reinvestment of equity during the seven-year NMTC period within such lender’s jurisdiction, and the flow-down of statutory and regulatory requirements under the particular grant or loan program to the project level. Common issues arising from combining CDE and government financing at the lower-tier Business Owner/project level are subordination, disbursement procedures and payment priority.
More NMTCs to Come
In addition to being able to participate in an NMTC structure, at least seven states have separate state-level tax credit programs in effect that mirror or complement the federal NMTC Program, and five states have pending legislation to enact similar state tax credit programs.
Real estate developers involved in an NMTC transaction must understand the technical requirements of the federal and state NMTC Programs and the innovative use of public-private partnerships in this challenging economic climate. Given the implications of failing to comply with these often complex requirements, having experienced advisors to counsel on these matters is critical.